Bankers lose interest! - How changing financial regulations affect all investors Bankers lose interest!
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1 Bankers lose interest! Bankers lose interest! How changing financial regulations affect all investors
1 Bankers lose interest!
Contact: Summary
Doug Steevens Lending is increasingly bypassing banks
Senior Portfolio Manager
and going directly through bond markets.
+44 (0)20 7086 9312 This is increasing the size of bond markets
douglas.steevens@aonhewitt.com
and changing their composition. However,
the costs of trading corporate bonds have
Contact:
risen, and investors need to ensure they
Steven Peake
are being adequately compensated for the
Consultant
risk of holding them. A lack of lending and
+44 (0)20 7086 9249
steven.peake@aonhewitt.com new developments in property markets
has created a supply freeze, and with the
economy growing, so too is demand. This
supports the outlook for property. Banks are
being penalised in certain business areas,
and the costs of transition management have
risen. Derivatives are being moved to being
cleared through an exchange, reducing
the risk of loss if a counterparty cannot pay.
However, this means more collateral posted
at the outset, making derivative strategies
such as liability hedging more expensive and
less flexible.2 Bankers lose interest!
Introduction Regulation
Stricter regulation of the financial sector is creating long Governments and regulators globally have introduced
term change in financial markets. Aon Hewitt has conducted rules to make the financial system more robust and stable.
significant research into the implications of these changes Banks need to hold more capital relative to the amount of
for our clients and they are far reaching. While this paper loans granted, so that they can withstand borrowers not
focuses on the long term issues, banks making fewer loans being able to repay. This means either increasing capital
will create some medium term investment opportunities for held, or reducing lending, or a combination of both.
new lenders to step in and profit. These will be discussed in Regulators are penalising banks which engage in activities
a separate note. which are deemed to be risky, so banks are changing their
business models.
Background
When anyone puts money in a bank account, they are
providing the bank with a loan on which the bank pays
interest. In turn, the bank lends to businesses, projects
and individuals at a higher interest rate, and typically over
several years. The bank profits from the higher interest rate
if all the loans and interest due are repaid. As the bank runs
the risk that borrowers cannot pay back all they owe, the
bank needs to hold capital to cover potential losses on
the loans.
In the early noughties, banks lent more and more to
riskier borrowers. They also did not hold enough reserves
to cover potential losses from borrowers not being able
to repay loans. When the Global Financial Crisis took hold,
governments around the world supported banks, and
banks reduced the amount of money they lent.3 Bankers lose interest!
Sector composition of sterling investment grade
Lending bypasses banks to go
corporate bond index
through bond markets
100%
The new regulations are very prescriptive and increase the
cost to banks of lending in certain areas. Banks are lending
80%
less to companies, but companies still need loan financing
to operate or expand their business. Therefore, companies
have increasingly issued debt (tradable IOUs, often called 60%
corporate bonds) directly to investors. As the chart below
shows, this has helped to significantly increase the size of 40%
debt markets, and we expect this trend to continue.
20%
10
9 0
8 2007 2008 2009 2010 2011 2012 2013
7 Financials Non Financials
Face value, US $tn
6
Quasi Government Securitised
5
4 Source: Merrill Lynch
3 It appears to be positive for corporate bond investors that
2 they are lending less to banks and are lending to more
1 companies as it spreads the risk that one issuer cannot repay
0 its debt. However, credit ratings of the debt constituting
corporate bond indices have also changed as riskier
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
companies have issued more debt.
Global High Yield US Bank Loans
Quality of sterling investment grade corporate bond
European and US Investment Grade Corporate
indices has declined
Source: Merrill Lynch
100%
In Europe, most lending goes through banks, and a minority
through debt markets. The opposite is true in the US. 80%
Therefore, lending moving away from banks to debt markets
will be a much larger process in Europe. 60%
…and changes bond 40%
index composition
20%
Credit rating agencies, such as Standard & Poors, assess
the ability of companies to repay their debts, and assign 0
corporate bonds a credit rating such as AAA (most 2007 2008 2009 2010 2011 2012 2013
creditworthy) AA, A, BBB, BB, B, CCC, CC and C (least
creditworthy). The largest corporate bond issues AAA AA A BBB
are classified into indices, and investors can invest Source: Merrill Lynch
passively in such indices which evolve as corporate bond
issuance changes. Those who invested in passive corporate bonds several
years ago, and have not changed the index being tracked,
As banks have reduced lending to companies, might assume that their investments are broadly similar.
non-financial companies have issued more corporate They are not, and investors should periodically review
bonds. The weighting of non-financial corporate bonds the index composition to check that they are being
in the sterling investment grade corporate bond market adequately rewarded for such changes and the risks
has risen from 23% to 37% since 2007 to the end of 2013, currently being taken.
with a corresponding fall in financial corporate bonds.
This is shown in the next chart, and the trend may
well continue.4 Bankers lose interest!
But watch the availability and costs Securitisation market growing
of trading corporate bonds Banks can continue to lend to different borrowers, and
then pool these loans together. The underlying loans can
Buying bonds when they are first issued (primary market)
be credit card debt, mortgages, car loans, or company
is straightforward, especially given increased issuance in
loans. The pool of loans is sub-divided (tranched) into
recent years. Once issued, bonds can be traded through
different securities, each with a different risk-return profile.
intermediaries such as banks, unlike shares which are
This is known as a securitisation.
traded on the open market. When wanting to buy bonds,
fund managers ask banks if they have the bonds and to Banks sell the securitisations to other investors, so that they
quote the price. Or, when selling, fund managers ask banks pass on the risk of borrowers not repaying their loans. For
if they are willing to buy and at what price. As banks need taking this risk, investors expect higher returns than cash
to hold some stock on their books for this activity, they interest rates. The banks can retain their relationship with
run the risk of the market falling in value. They are borrowers and earn a fee for arranging the securitisation.
rewarded for this risk by buying bonds at a lower price Key entities within Europe, including the European
than they sell them at.
Commission, believe that securitisations play an important
New regulations mean that banks are not holding as much role in financial markets. They allow banks to continue to
corporate bond inventory as they used to. This has made provide loans, but to manage the risk of loans not being
it harder to buy and sell corporate bonds and the cost of repaid. But, regulation may need to be relaxed to make
doing so is higher than before the financial crisis (the gap is this attractive for banks. Indeed, the European Central Bank
higher between the purchase and sale prices). It now costs is looking to directly purchase securitisations to stimulate
around 0.8% to buy and sell passive UK corporate bonds. lending to companies.
Investors therefore need to evaluate whether corporate As the chart earlier shows, securitisations have increased as
bonds are providing a sufficiently high return after a proportion of the UK corporate bond market.
allowing for such transaction costs. We view corporate
bonds as only having a narrow advantage over equivalent
government bonds. Investors with significant amounts Effects on commercial property market
of corporate bonds should consider other approaches The property market in recent years has been characterised
to make returns from the bond markets, such as absolute by a lack of new development projects and less money has
return bond strategies, total return bond strategies and been spent on existing assets. With the economy picking
multi-asset credit. up in the UK, tenant demand is improving on a more
Corporate bonds should not be traded frequently. widespread basis and we have seen property producing
Transaction costs can be reduced by transacting in pooled strong returns recently. As it will take time to increase the
funds at quarter ends when many other investors are supply of property, the outlook for the market is positive
rebalancing portfolios. If there are many buyers and sellers over the next few years.
of a fund on the same day, the manager can match these
off at zero transaction cost, as they do not need to buy or
sell underlying bonds.5 Bankers lose interest!
Larger, less competitive, Private lending
transition managers Many entities that have traditionally been reliant on
banks for their borrowing needs are finding that, due
Regulatory pressures mean that banks are reducing or
to regulatory changes, financing is less forthcoming
exiting business units with low profit margins or which
than it used to be. However, they are often too small to
are not their main focus. We have already seen major
raise finance by issuing their own bonds. This creates an
banks such as JP Morgan and Bank of New York Mellon
opportunity for institutional investors, such as pension
exiting from the transition management business. This
funds, to provide the financing these parties require.
makes a small pool of transition managers even smaller
We look at these opportunities, which include financing
and has driven up costs for pension schemes using
infrastructure and property projects, in more detail in a
transition managers.
separate note.
More transparency in derivatives… Conclusion
but less flexibility for investors Investors have traditionally held corporate bonds to
Regulatory changes are also changing the way derivatives provide a higher return than government bonds. With
are being traded. Take an interest rate swap as an example. the additional yield over government bonds now much
Here, one party to the contract periodically receives a fixed lower than it has been in recent years and with trading
amount and, at the same time, the other party receives costs high, investors may wish to consider alternative
an amount which varies over time with short term interest approaches. A lack of lending and development has
rates. These two payment streams are calculated to be created a supply-demand squeeze in the UK property
worth the same at the outset but, over time, their values market, which should perform well. Transition management
will change; one party will make a loss and the other a gain. has become more expensive. Derivative markets will
The party that makes a loss must put money in an account become more robust, but also more costly and less flexible.
to cover this loss, which is known as posting collateral.
Such derivatives will now be traded through an exchange,
which is a counterparty that acts as a middle man. To
protect the exchange, investors will also need to post
collateral at the outset to cover potential future losses.
This will make derivative strategies, such as liability
hedging, more costly and less flexible. The positive side
is increased confidence in the derivatives market and
greater standardisation of products for investors.6 Bankers lose interest!
Disclaimer
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law on any particular aspect or in any specific case. It should not be taken as financial
advice and action should not be taken as a result of this document alone.
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